The Investment Idea that made Warren Buffett Billions

Last week E.J. posted part I in his series on Benjamin Graham’s The Intelligent Investor. You may have heard this from us before, but it is worth repeating for the benefit of those who have not. The Intelligent Investor truly is the best investment book ever written. It is a timeless classic that remains as relevant today as it was when it was first published over six decades ago.

Not a single investment book comes close to providing the fundamental insights that Graham so masterfully delivers in The Intelligent Investor. If you don’t yet have a copy, order one today. It will be the best $15 investment you ever make. And if you missed E.J.’s excellent three part series on The Intelligent Investor be sure to catch it here.

I am not going to write about The Intelligent Investor today. Instead I am going to write about one of Graham’s other major contributions to investing, what I would argue is his most important contribution to investing. It is the idea that is central to Warren Buffett’s investment strategy. An idea that helped him make his billions. It is an idea that lies at the heart of my own investment strategy, Young Research’s strategy, and the strategy we pursue for clients at Richard C. Young & Co., Ltd.

What is this billion dollar idea I am talking about? It is the concept of a Margin of Safety. You have probably heard the terminology before. The investment industry is loaded with managers who claim to invest with a margin of safety. Just skim the marketing materials of five actively managed mutual funds and you will likely see the phrase mentioned in four out of the five. But the reality is that while many investors claim to invest with a margin of safety, few actually practice what Graham had in mind.

Graham first introduced a margin of safety with David Dodd in Security Analysis. This is from the fifth edition of the book.

The presence of a margin of safety is the distinguishing characteristic of true investment.

…

In the case of a common stock, it would be represented by a goodly margin of calculated intrinsic value over the current market price. However, in the selection of primary or leading common stocks for conventional investment, such a margin between value and price has not typically been present. In these instances the margin of safety is contributed to by such qualitative factors as the firm’s dominant position in its industry and product markets and expected earnings growth.

In the 1973 edition of Intelligent Investor Graham says the following about a margin of safety.

Probably most speculators believe they have the odds in their favor when they take their chances, and therefore they may lay claim to a safety margin in their proceedings. Each one has the feeling that the time is propitious for his purchase, or that his skill is superior to the crowd’s, or that his adviser or system is trustworthy. But such claims are unconvincing. They rest on subjective judgment, unsupported by any body of favorable evidence or any conclusive line of reasoning. We greatly doubt whether the man who stakes money on his view that the market is heading up or down can ever be said to be protected by a margin of safety in any useful sense of the phrase.

Investors who demand a margin of safety recognize that the future is uncertain. This may sound obvious, but many investors buy and sell securities as if they have perfect foresight. Just look at the valuations of Netflix or Tesla. Netflix is trading at 110X next year’s earnings. The company’s future may in fact turn out to be as bright as the buyers of the stock assume, but what if it is not? What if a formidable competitor emerges or what if content creators stop licensing their content to Netflix, or what if internet providers start charging Netflix more for bandwidth? At 110X earnings, Netflix has no margin of safety. If the company stumbles, investors in the stock are likely to suffer badly.

As Graham points out, “a margin of safety is the distinguishing characteristic of a true investment.” Anything lacking a margin of safety is speculative.

How can you put the concept of a margin of safety to work in your portfolio? I can tell you what we do. I’ll give you the highlights this week and expand on each strategy in a future post.

First we only buy stocks that pay dividends. Dividend payers tend to fall less than non-dividend payers in down markets.

Second we favor high-quality businesses, companies that operate in industries with high-barriers to entry, and those with a sustainable competitive advantage. When economic turbulence hit, higher quality business are more likely to weather the storm.

Third, we look for opportunities in stocks that are out of favor. Buying out of favor shares is the opposite of investing in Netflix at 110X earnings. If an out of favor company stumbles, its stock may not even decline because investors have probably priced in a gloomy future.

There you have it. To add a margin of safety to your portfolio buy high-quality dividend payers and if you can find them (not easy in this market), buy the ones that are out of favor.

Jeremy Jones, CFA

Jeremy Jones, CFA is the Director of Research at Young Research & Publishing Inc., and the Chief Investment Officer at Richard C. Young & Co., Ltd. Jeremy is a contributing editor of youngresearch.com.